Friday, August 21, 2015

Worrying Signals from the Bond Market

Along with today's decline in equity markets, treasury yields and inflation expectations also declined. Five year forward inflation breakevens are now at 1.13%.

Here is an update of the graph I posted a few days ago, showing that short term TIPS yields have pushed even higher. It's a little hard to pull out of the data, because TIPS markets have only recently developed, but this pattern of large premiums in short term TIPS yields also emerged in the summer of 2007 when the Fed signaled ambivalence about early difficulties in the mortgage market and emerged again before the fateful September 2008 Fed meeting. I don't see a sign of this pattern at other times. For instance, forward inflation expectations dipped down after the first two rounds of QE ended, but short term TIPS didn't signal deflationary shocks at those times.

Looking at the forward Eurodollar markets, I also see worrying signals. The recent fall in interest rates has not been associated with a shift forward in time of the first rate hike. That is still expected to happen between in October or December, as it has all summer. The expected date of the first rate hike had been moving ahead in time, remaining about 6 months in the future. During this time, I read the bond markets as gaining confidence. The yield curve at the very short end slightly flattened, but the terminal rate moved up nicely, signaling higher expectations for both inflation and real rates to move toward the Fed's stated goals. But, in June, bond markets appear to have accepted a resolve from the Fed to raise rates this year. The expected date of the first rate hike stopped moving forward, and when it did, the slope and terminal height of the yield curve began to decline, along with inflation expectations.

And now, in the past few weeks, we have TIPS markets signaling a deflationary scare. All of this, together, says to me that the bond markets do not have faith that the Fed will respond to current weakness in a timely manner.

If the bond markets are right, the question is, "Is this August 2007 or September 2008?". On the one hand, there is some positive momentum in labor markets and industrial markets (outside of oil exploration). There is no momentum in construction or real estate credit to destroy. I take this as a sort of positive. There is not a lot of activity to undermine there. The economy's momentum is not dependent on real estate. And, even though the zero lower bound distorts the yield curve, the long end of the curve is around 3%, and I doubt that it could distort it that much. Normally, I wouldn't worry about more than a minor equity correction if the yield curve is not inverted. Also, corporate leverage is low, profits are strong, and valuations are reasonable. Equities shouldn't collapse unless there is a collapse in nominal incomes that creates a deep decline in corporate profits, like it did in late 2008. Those factors suggest that the initial reaction to a hawkish error wouldn't necessarily be disastrous. Equities didn't peak, surprisingly, until October 2007, and slowly declined by about 3% a month after that. Profits had been falling slowly since 2006. The collapse in equities in late 2008 was more or less proportional to the collapse in earnings that came after the September-November 2008 tightening. On the other hand, 5 year forward inflation expectations are about where they were in September 2008.

It is certainly time to start thinking about forms of defense. I'm not sure there is a safe and inexpensive hedge available. Directional positions are dangerous, because they are basically a bet on the arbitrary decision of a committee of political appointees. It's unfortunate that we impose this sort of uncertainty on ourselves. Regardless of the policy decisions that happen as we move forward, how many productive activities are on hold now because of the uncertainty? Even if we didn't have a market-based currency regime, wouldn't it be nice if the committee could quickly do something like simply announce that they would buy $100 billion/month of new treasuries until 5 year inflation expectations increase to 2%? It seems to me like a conservative position to take, but it would be made out to be a big deal. And, everyone from Rand Paul to Bernie Sanders would be talking about how the Fed was just covering Wall Street's backside, as if the only problem we have is a drop of a few points in equity markets. As if labor and capital aren't part of a symbiotic relationship where early signals of trouble for both are often visible in capital markets.